Risk Management in Islamic Banking

IS THERE SUCH A THING AS ISLAMIC RISK MANAGEMENT?

I had this conversation recently until the wee hours of morning, and although I never thought a lot about it, I have come to the conclusion that there cannot be an exact replica of the Risk Management in the conventional sense.

Risk Management is a tool used by all conventional banking institution in the name of good governance, risk mitigation and prudent practice. It looks at financial exposures and its inherent risks to the business, and deeply believe in the risk-rewards pay-off within the generally accepted risk appetite of the organisation. It focuses a lot on control processes, performance monitoring, collateral value, and decision making policies for credit, market and systemic risks.

To a large extend, the risk management framework employed by the conventional banking businesses can be easily adapted by Islamic Banking counterparts. The components are the same, and there is little argument on its applicability under Shariah law. However,  the risk management framework for Islamic Banking institutions must be inherently different as well, or maybe extended to include a bigger scope. It cannot just be seen as a replica of the conventional business; the foundation of Islamic Banking is definitely different.

There are a few divergence in the reason an Islamic Banking institutions should (ideally) follow. This is an on-going argument on the fact while Islamic Banking claims to be a different business model, but it is still engineered by the rules of a conventional organisation. But what are these divergent reasons for setting up an Islamic Banking business?

The lending of money to make money is forbidden.

This may seem like a trivial thing for Islamic Banking as many will say there is no difference between profit and interest. But for us practitioners, there is a big difference in its concept. Because of this difference, the way we think about how a product can be structured is paramount. Underlying contracts, assets, ownerships and roles and responsibilities becomes different from a tranditional / conventional bank (whom are essentially a money lender). To validate a transaction, all tenets and requirements in an Islamic contracts must be met or else it becomes an invalid transaction and any gains from it must be given to charity. Any gains obtained without fulfilling the transactional can be deemed as usury (riba’).

There are specific Shariah requirements that takes Islamic Banking beyond banking.

Some terms are pretty alien to traditional banks, such as commodity purchase, operating lease and rentals, sequencing and ownerships. This is where the divergent begins, because Islamic Banks espouses the concept of “trading” and “entrepreneurship” and “partnership” and “service provider”, away from the “lender-borrower” arrangement. Traditional banks struggle to understand issues of ownership of assets, risk and loss sharing, purchases of commodity and rental of assets. These activities are beyond traditional banking, and may become an operational risk issue if it is not fully embraced.

Islamic Banking should be more closer to a venture-capitalist, crowd-funding model than traditional banking.

The fundamental requirements for earning a profit (and to a bigger extent, how much we can earn from a transaction) is the element of risk sharing, which mean both customer and financier takes some form of the risks of the venture. At the same time, such “risky” venture is mitigated by way of ensuring it is not overstretched i.e. the transactions must be either asset-backed (including the presence of collaterals) or asset-based (evidenced by real trading or assets or commodities) to reflect economic activity.

The amount of risk taken under an Islamic contract can be higher (for contracts such as Mudharabah or Musyaraka financing) but it must be reflective of the economic reality and available assets.

The risk assessment of an Islamic contract must then be enhanced to behave similarly to what a venture capitalist can accept. There will be direct risks on equity, investments and returns. There will be corresponding returns as well. But such concepts will be difficult to digest if the bank is set up based on traditional banking fundamentals, which caters for a totally different profile of stakeholders.

As far as possible, the Shariah committee draws a line for transparency, fairness, and justice.

Islamic Banking should be an extended but integral part of economics. Islamic Banking is supposed to be more than a bank. It shoulders a broader responsibility to the people by looking at needs and providing products that serve a purpose. The idea of responsible financing, transparency and customer service should be the by-word of an Islamic Bank. The payment of Zakat (tithe) on profits which goes back into the community recognises the financial role that it needs to play. Corporate Social Responsibilities also play a role.

In this repect, the Shariah committee plays an important role as gatekeepers to the products and services on offer. Because of the unfamiliar territory of Islamic products, Shariah insists that transparency is critical to avoid uncertainty (gharar), the terms to the products are fair and the banks are ethical in its conduct to ensure justice. Fees and charges must reflect actual costs. Efforts are made to help a customer in distress. And conduct of the bank must comply with the requirements of Shariah.

SO, BASED ON THE ABOVE, WHAT ARE THE  OF RISKS FACED BY ISLAMIC BANKS? 

As a general rule, all risks faced by a conventional Bank must be “transferable” i.e the nature of the financial transaction must, as far as possible, allow for the TRANSFER OF RISKS. Wherever the opportunity arises, the Bank must be able to quickly pass the risk of the asset or valuation to the customer. Such understanding is also apparent in Islamic Banks. Looking at most Islamic Banking contracts, their structure allows for the transfer of risks, which follows the transfers of ownership, responsibilities and obligations from one party to the other. Contracts  such as Murabahah, Musawamah and Qard works by transferring the ownership, responsibilities and obligation from the Bank to the Customer.

Alternatively, mostly exclusive to Islamic Banks, are structures that allows for SHARING OF RISKS. The structure is more “participative” in nature, where there are benchmark by which determines the level of risks a party should have. The regular types of contracts that continues to share risks are Mudarabah, Musyarakah and Ijarah.

COMMON RISKS 

As mentioned before, the risks faced by a conventional bank and Islamic Bank should be very much the same, except for risks arising to the execution of Islamic contracts or pronouncement of the Shariah. While there will be common elements of risks for both types of Banks, the importance of Shariah ruling and decisions result in Islamic Banking becoming so unique. The following are the Risks commonly faced by Islamic Banks:

GENERAL RISKS – Risks existing in both conventional and Islamic banks. 

  • Credit  Risks – Arises due to counterparty risks (possibility of default by the party taking financing) where the counterparty fails to meet its obligations, in terms of payment, uncertainty of industry,  change of direction or diminished collateral value. This lead to settlement risks which means the Asset quality has diminished.
  • Market Risks / Interest Rate Risks – More macro in terms of effect on the risks. It relies on the performance of the market as well as the quality of the financial instruments (price, performance, valuation, demand, yields and inability to reprice. It leads to exposure to interest rate risks, where the risk of the bank increases with movements in the rates.
  • Liquidity Risks – Refers to the risk of inability to return cash to investors or stakeholder in stressed scenarios, resulting in forced borrowings from the market (usually at higher price) coupled with the possibility of not able to dispose assets. This may lead to valuation risks.
  • Operational Risks – Due to inadequate control of internal processes and operational practices, the risks may result in real loss of income and potentially reputation. Human errors may be difficult to unwind especially if there is financial implications. There may also be legal risks as it may be considered a breach in contract by the bank.

ISLAMIC SPECIFIC RISKS – Risks arising from operational and processing function

  • Transactional risks – Especially under Islamic Banking structures, transactions play an important role as part of the Aqad, where required.  For example, the sequencing of a Murabahah transaction. Failure to ensure compliance to the Aqad requirements will lead to potential invalid transaction and loss of income (or flow to charity).
  • Valuation Risks – Due to the nature of some Islamic Banking contracts, especially equity based structures, there will be challenges in valuation of the portfolio.  Reduction in valuation will result in real losses for the investors.
  • Displaced Commercial Risks – Displaced Commercial Risk (DCR) refer to the risk of mismatch between the fixed/contracted obligation to the depositors vs the uncertain returns on the financing (income) which may result in the income is insufficient to meet the obligations to the depositors. For example, the commitment for Islamic Fixed Deposit is 4% (contractual) but the Financing portfolio into which the Fixed Deposits is deployed into only earns 3% (actual returns). Therefore, the 1% shortage is the DCR where the Bank will have to flow 1% of  income from other portfolio to meet the deposit obligation of 4%.

SHARIAH RISKS – Risks arising to non-compliance of Shariah decisions and Shariah instructions.

  • Shariah Compliance Risks – The operation of an Islamic Bank is hugely dependent on the requirements of the Shariah Committee and approvals obtain on the process and procedure. Inability to comply with Shariah requirements puts the operations of the Islamic bank at risk as the department may be regarded as non-Shariah compliant business.
  • Fiduciary / Ownership Risks – Some of the structures under Islamic contract requires the bank to operate outside the scope of a financial intermediary. It requires the bank to hold property or trade commodities or own and lease assets, with various contracts using various roles and responsibilities. The risk of multiple roles and function must be clearly defined and implemented.
  • Regulatory / Reputational Risks – Changes in regulations requires quick adaptation to ensure compliance to regulation and maintaining the banking reputation intact.?

SO HOW DO YOU MANAGE ISLAMIC RISKS AND SHARIAH RISKS

As mentioned, Islamic management of risks should not be any different for the base of conventional bank’s methodology of measuring risks. There must be deep understanding of the products and structure for the bank to be able to assess the risks associated. To manage an Islamic Bank and its risks, the bank must first identify each of the risks and form safeguards to settle the above. Then only an Islamic bank can formulate suitable controls to ensure the Shariah specific processes and Shariah pronouncements are being monitored and implemented with sufficient support (internal or external). Wallahualam.

The All New Shariah Advisory Council BNM Website

THE ONE-STOP SHARIAH ADVISORY PAGE OF BANK NEGARA MALAYSIA       

Finally it is here, the website dedicated to the works and reference regarding the Shariah Advisory Council (SAC) of Bank Negara Malaysia. There is a wealth of information on the decisions and fatwa of the SAC, and this will provide valuable reference point on how a particular decision is made. Good insights especially to leaners interested in knowing the methodologies and depth of deliberation that the SAC employs for a decision.

The Centre of Shariah Reference in Islamic Finance

The website itself looks clean and uncluttered and holds various sections of interest. They include:

  • Shariah Standards & Operational Requirements. Currently it covers the 12 Islamic contracts standards that has been issued up to today (21 April 2018). You can view the various standards individually as you scroll down the page. Click on the banner below to go to:

  • Shariah Resolutions 1997 – 2010. This is the English-language compilation of the various resolutions when the industry was in the infancy stages. Lots of very fundamental discussion happenning during this period in the industry. Click on the banner below to go to:

  • Shariah Resolutions 2011 – 2017. This is the continuing compilation cover a more advance level of discussions, as the products in the market become more sophisticated, More importantly, the introduction of Islamic Financial Services Act 2013 (IFSA 2013) provided a more robust consideration of operationalisation of the Islamic contracts. Personally, I learned quite a number of concepts during this segment of time. Unfortunately at the moment, the compilation is in Bahasa Malaysia (Malaysian language). Click on the banner below to go to:

  • Educators’ Manual. This section interestingly mentions the existence of manuals for learning organisations that teaches Islamic Banking and Finance courses. I am sure these are useful documents if it is coming from the SAC. But you need to sign up and agree to adopt the standards for your institution to access these. Therefore I can’t really comment on the contents. Click on the banner below to go to:

  • Latest Shariah Rulings (Individual SAC Meeting Resolutions). This section allows the reader to have access to the decisions made on certain specific issues. It aims to provide the reader the understanding of how a decision is derived, based on relevant Fiqh evidences. Interesting read and quite comprehensive. Click on the banner below to go to:

  • Infographics. I believe this is part of the efforts to educate the public on the understanding on the workings of Shariah contracts as well as the process flows (and Shariah requirements) of a particular Islamic structure. As at current date, there are only 3 Infographics available ie Tawarruq, Istisna’a and Murabahah, but I am sure over time, the number of contracts infographics will grow. Click on the banner below to go to:

  • List of Shariah Committee Members in Islamic Financial Institutions. This is an interesting section because of the willingness to disclose to public the Shariah scholars responsible for the resolutions or opinions at the institutional level. It provides transparency and also reference of the Shariah Committee strength compared between Islamic Financial Institutions. Click on the banner below to go to:

There are many other sections in this website and I personally believe that this site will be one of the most complete point of reference for all the Shariah-related banking decisions. It   may provide a better understanding of how the SAC makes a resolution that impacts the overall industry. I personally encountered a few glitches but I hope the content accumulates further to finally become one of the prominent sites when it comes to Islamic Banking.

Also, hoping someday the website will publish a hardcopy of the resolutions because some of us do read actual books. But if there is a plan for an e-book, do let me park it here on my website. For free.

Overall, I think the SAC website looks awesome and would definitely be one of my reference website for Islamic Banking products, processes and issues.

P/S Somehow I am not able to register as a subscriber yet (April 2018). Maybe still developing this area of the website? Hope it is sorted out soon.

Where Regulations on Islamic Banking Lives

Many times I have been asked, during talks and sharing sessions, where we can find all the Regulations, Frameworks and product Policy Documents issued by Bank Negara Malaysia. Many are not aware that I do house most of the relevant documents right here in my site. It is hidden (actually, not hidden…) in my REGULATIONS (MALAYSIA) tab.

Most of it are very technical documents and perhaps will make sense more for the practitioners in the industry. But there are many documents that is very useful, even for academicians and students, which is concisely well written and captures the essence of what needs to be conveyed. Especially documents such as the Islamic Banking contracts, which you can find at the PRODUCT STANDARD / POLICY DOCUMENTS (PRODUCTS) section of the same page.

Also there, the latest Shariah Advisory Council (SAC) Resolutions and Updates on various resolutions under under SHARIAH RESOLUTIONS.

Do use it if you are looking for a place for your reference. Also you can click on the above banner to go straight to Bank Negara Malaysia Website to search for items that are not in my page.

Happy Reading and do share the page if you find it useful.

Religiosity

Sometimes, as a practitioner, we wonder what motivates a person to subscribe to Islamic Banking products. Is it really based on the attractive features of a product, trying out something new, or is there an ingrained desire to subscribe to a Sharia compliant product? I know many non-Muslims subscribe to Islamic Banking products based on the intrinsic benefits afforded by the products, such as a more fairer penalty terms, transparent fees and charges, and flexibility in settling the accounts early.

But what of Muslims? How can we understand the triggers that encourage a Muslim to subscribe to a Sharia-compliant product?

I came across this writing by Dr Hanudin Amin which mentions a term that I hardly hear in the industry; Religiosity. It refers to the conceptual level of a person’s “piousness” to be marked into different levels (index), and he aptly split it into 3 general categories i.e. 1) Pious Religious, 2) Moderately Religious, and 3) Off-Hand Religious. His paper suggests that the Pious Religious group tends to accept Islamic Banking products more compared to other groups (in his study it’s focused on Home Financing-i). It also proposes that perhaps it is worthwhile to consider packaging Islamic Banking products based on the different levels of “Religiosity” to better appeal to them. This may indeed widen the scope for acceptance as products may be perceived differently by different people, although essentially it is the same product.

To read a bit more on the study, do have a read on the research below.

RELIGIOSITY INDEX FOR ISLAMIC HOME FINANCING IN SABAH

By Dr Hanudin Amin*

Excerpt :Earlier muslim scholars have supported the finding that a consumer’s religiosity has a significant effect on consumption in a muslim context (e.g. Elgari, 1990). Someone who approaches an Islamic bank for a mortgage is endowed with a certain level of iman. Bendjilali (1995) believes that choosing interest-free financing is blessed by Allah (SWT), hence it is rewarded. Bendjilali (1995) points out that:  “A muslim consumer who approaches the Islamic bank to get a loan for a real transaction to be financed through murabaha mode is endowed with a certain level of iman. The degree of iman will indicate the degree of compliance to the Shariah”.

For full Article, click on this link.

Tell us what you think. Should Islamic Banking products designed to a specific level of religiosity or can the one-size-fits-all approach appeal to everybody? Comments appreciated.

*The author is an Associate Professor/Dean at the Labuan Faculty of International Finance, Universiti Malaysia Sabah, Labuan International Campus. He has a PhD from the International Islamic University Malaysia (IIUM) in Islamic Banking and Finance (PG310163). He can be contacted at hanudin@ums.edu.my

Islamic Banking Operating Model

For the past few months, there have been some earnest discussions on whether Islamic Banking is operating under the right model or type of institutions. Comments by prominent scholars on the suitability of certain Islamic contracts in a financial institution sparked debate on the types that are suitable for operating Islamic contracts. Before I attempt to also put my piece in the mix, there were also questions asked to me on which of the existing models can actually be the right fit. There is still confusion on the types of institutions operating in the market.

Before we look deeper, it is worthwhile to recap the available models in Malaysia.

THE ISLAMIC WINDOW OPERATING MODEL

We  have to start somewhere. Islamic Windows as a starting point, provides the best opportunity to build capabilities at the lowest costs while the business is being developed. The intention is to identify the requirements for system and invest minimally to assess feasibility and operational gaps. This allows the Bank to build the infrastructure at an acceptable pace. This is also a pre-cursor to further/larger infrastructure investments if there is a decision to expand the business into a subsidiary.

This model relies on the existing conventional infrastructure where all the processes, operations, sales, channels, finance, branches, compliance, audit and all functions are provided by the conventional bank. It is a leverage model where the Islamic Banking Windows are more like a “manufacturer” of products. Islamic Banking Windows churn out the products and services (like a factory), and delivers them to the conventional team as part of the suite of products offered by the conventional bank. In such structure, Islamic Banking Windows are just a “segment” of products on offer. Just like Corporate Banking products. Commercial Banking products. Wholesale Banking products. Private Banking products. Retail Banking products… and Islamic Banking products.

The advantage of this model is the low set-up cost. The business rides on existing infrastructure and hires specialists in each function. There is no need to set up a different branch as those Islamic products are sold directly by the existing branches and channels sales team. Balance Sheet discloses Islamic Banking Window performance as part of the Notes to the Account. Shareholders’ Capital, however must be separately allocated, accounting ledgers managed separately and the Single Customer Exposure Limit (SCEL) will be 25% of the allocated Capital. A head of Islamic Banking Windows will report directly to the conventional banking CEO, where business decisions are made.

Not many banks operates under the Islamic Banking Windows model. The main reason is the lack of product range i.e. competing with conventional banking products of the same branch, and the small scale of business limited to its SCEL, and no autonomy of business decision which must be aligned with conventional products.

THE ISLAMIC SUBSIDIARY  MODEL

Islamic Subsidiary rides on the strength of the Parent Bank, which is the conventional bank. The model used is still a leveraged model, but the Islamic Subsidiary can choose which services or function they want to “outsource” to the conventional bank (at a fee chargeback, of course). The idea of a Subsidiary is to be independent, so all cost consideration must be taken into account. Decision to open Islamic Banking Branches can also be made, and BNM supports this expansion via Islamic Banking Branches.

However, being a Subsidiary Bank can also be a burden to set-up. A differentiated system or process or operation team requires cash for its set-up. At the early stages, such investment cash will be limited, and when cash is available for investment, the development of the Subsidiary Bank must then align with the conventional bank. So it can be a chicken and egg situation where to expand you need to earn but to earn you need to expand (and spend).

Most of the conventional banks offers Islamic products via Islamic Banking Subsidiary. The main advantage is that decisions are autonomous in a Subsidiary, there is more control of marketing and sales and branches, and the Bank (as an independent entity) can chart its own course. However, there will still be influence from the parent (as the majority shareholder) and the products and services offered are generally aligned to the products and services offered by the parents. The SCEL for Subsidiaries are also dependent on the strategy of the parent Bank, where it can choose to invest heavily or adequately for the operations of its subsidiary.

FULL FLEDGED ISLAMIC BANKS

These are standalone banks that generally are not under any conventional banking influence. The products and services may be consistent with the offerings in the market, but it is not an obligation to follow. In theory, Full Fledged Islamic Banks have the capacity to offer new-to-market products, based on the approvals obtained from Shariah Committees and BNM.

There is room for innovation and experimentation of new structures via Full Fledged Islamic Banks, although they must still governed by the financial ratios and controls for other types of banks and financial institutions, using conventional measuring tape which could lead to a “penalty” cost for doing business.

For example, a debt based home financing based on Tawarruq will incur a capital charge of 50%-100% but in a Musyaraka Financing, that capital charge will cost 100%-400% which will be an “expensive” proposition simply because it is measured against conventional financial ratios.

Personally, I believe Full Fledged Islamic Banks should follow a different set of financial ratios catered to reflect the type of risks an Islamic Bank CAN take, should the Islamic Bank look to offer products such as Mudaraba, Musyaraka, Istisna’ or even Salam. To allow for pure innovation, the financial ratios and treatment of capital and assessment of risks should be differentiated to reflect the nature of the products offered. While Basel requirements can be used as benchmark to ensure stability, an “Islamic” Basel will be even more meaningful where it can fully address all the real risks faced by Islamic Banks deploying Profit Loss Sharing (PLS) and equity-based structures such as Mudaraba and Musyaraka. Slowly, BNM is recognising these differences for measurement and has taken small steps to differentiate, such as the introduction of treatment of Investment Accounts (IA), the Liquidity Coverage Ratio (LCR) treatment, Capital Adequacy Framework for Islamic Banks (CAFIB), and the removal of Reserve Funds (reserves from paying of dividends) from Islamic Banks recently. It is my sincere hope to one day see an “Islamic” section in future Basel releases as well.

The main challenge for a Full Fledge Islamic Bank, is the costs of building the franchise from ground zero. To compete with a conventional bank, the Islamic Bank must invest similarly in its infrastructure and achieve operational efficiency and scale as soonest as possible. The payback period and Return on Investment and Return on Equity remains important for long term sustainability. SCEL is dependant on how big the Bank intends to grow. Another key consideration is the ability for the Islamic Bank to build a strong source of cheap deposits for the funding requirements.

NOTE

Of course there are other structures that can be attributed as Islamic Financial institutions such as cooperatives, development banks, and investment banks. But the most common are the above variations and these structures fit into strategies identified by the bank. In most cases, BNM prefers to see development coming from the Full Fledged Islamic Banks and Subsidiaries. These should be the drivers for the growth of Islamic Banking.

Wallahualam

Popular Islamic Finance Terms

While Islamic Banking in general has been codified since early 1980’s in Malaysia, the familiarity to Islamic Banking or Finance terms remain a challenge. Terms like Mudarabah or Musyarakah or Wakalah remains difficult to remember but also it’s meaning have been lost to many, although there has been many attempts to communicate the various glossaries already available.

This makes the layman to go back to something more familiar, in most cases it is conventional banking, simply because of the ingrained understanding of conventional banking terms and terminologies. Some become “allergic” to Islamic terms simply because of the fear of failing to explain and understand the “arabic” terms. It does seem a daunting task to remember the terms, and understand what they mean.

So, I picked up a simple slide from a friend from IBFIM ie Haji Razli Ramli (his introduction available here in this website – click here) and made it into  a simple slide.

Get familiar with the terms for Islamic Finance, the easy way. Click on this 1-minute video. Share this video with friends. Know the meaning of those Arabic word. It’s quick and simple. In both English and Bahasa Malaysia. Comments are also appreciated.

Also, you can download the file into your desktop or mobile at the following links:

Share out to your friends. Thank you.